The Urge to Merge, or Vice Versa?

01/01/2015 | Kennedy Maize

Mergers and acquisitions have long characterized the modern power industry, going back decades. That looks to continue. But the dynamics of the industry are producing a counter trend, which the financial gurus describe as “carve-outs,” or addition by subtraction.

The urge to merge, a key feature of the power industry for the past 20 years or so, showed no signs of slowing in 2014. Major players sought to beef up their asset portfolios and diversify their generating profiles in a year marked by slow but steady economic growth. But a new phenomenon has emerged. Power companies are examining a relatively unusual business strategy: the “carve-out.”

James Surowiecki, economics writer for TheNew Yorker magazine, looking at merger and acquisition (M&A) activity in general, commented recently that there is “something odd going on: the urge to merge has been accompanied by an urge to purge.” He adds, “The brute fact is that most mergers don’t work.” Surowiecki cites Aswath Damodaran, a finance professor at New York University, who claims, “More value is destroyed by acquisitions than by any other single action taken by companies.”

A recent joint report by consulting firms Strategy& (formerly Booz & Co.) and PwC, “Carving Out Value: How Utilities Can Grow By Shrinking,” observes, “Shrinking demand and falling prices in electricity markets, and resulting drags in stock valuation, are leading some utility company executives to reassess their portfolios. In some cases, separating business lines that no longer fit together can build shareholder value by turning a larger, more diverse company into two strategically focused companies with stronger growth prospects and greater investment appeal.”

The report notes that the conventional wisdom in the past, as utility executives contemplated their business environment, was to bulk up. Mergers and acquisitions, the study says, were aimed at producing “economies of scale, broader operating platforms, and bigger balance sheets to fund future investment in a growth-challenged industry.”

Merge and Grow

That remains the path that most aggressive power industry executives are taking, PwC deals leader Jeremy Fago says. According to Fago, “Companies in the power and utilities industry are strategically pursuing assets, including those in close proximity to their existing geographic markets and/or with similar business models, to drive scalable growth and achieve operational synergies.”

In its report on utility M&A activities for the second quarter of 2014, PwC observed “a large increase in the volume of and value of deals greater than $50 million.” The quarter saw 13 deals that met this criterion, compared to seven each in the first quarter of 2014 and the second quarter of 2013. The deals are also bigger, PwC said: “Total deal value increased by almost 700% from the previous quarter from $4.4 billion to $34.9 billion.” The value of the average deal in the quarter rose from $626 million to $2.7 billion.

The megadeals of 2014 were Exelon’s buy of Pepco for $12.2 billion and Wisconsin Energy’s purchase of Integrys for $9.1 billion. Chicago-based Exelon announced April 30 that it would gobble up Pepco Holdings, based in the District of Columbia, creating a combined company of some 10 million customers and a $26 billion rate base. Exelon, itself created by a series of mergers, has been one of the most aggressive power companies in the M&A field for many years. Both companies’ shareholders have approved the deal, but it is still going through regulatory reviews at the state and federal levels.

In June, Wisconsin Energy Corp. of Milwaukee, a combination electric and gas utility, agreed to buy Chicago-based Integrys Energy Group, a gas-electric combo that includes Peoples Gas of Chicago (Figure 1). The new company, WEC Energy Group, will have some 4.3 million customers in Wisconsin, Illinois, Michigan, and Minnesota, with a regulated rate base of $16.8 billion. The companies face the usual gamut of regulatory approvals and say they expect the deal to close in mid-2015, although that is probably optimistic.

1. Snapped up. Wisconsin Energy Corp.’s acquisition of Integrys Energy Group includes a suite of coal, gas, and hydroelectric power plants, including the four-unit, 981-MW Weston Power Plant near Wausau, Wis. Courtesy: Royalbroil/Wikipedia

The PwC second-quarter report highlights four other billion-dollar-plus deals:

■ Berkshire Hathaway Energy Co. in May announced a deal to buy AltaLink LP, based in Calgary, Alberta (and owned by SNC-Lavalin) for US$5.5 billion. AltaLink is an electric transmission company that owns about 60% of the electric grid in Alberta. Omaha-based Berkshire Hathaway Energy owns a number of electric and gas companies including MidAmerican Energy, PacifiCorp, NV Energy, and Kern River Gas Transmission.

■ LS Power Equity Partners, an employee-owned non-utility generation and transmission business, in April agreed to buy six power plants in the Southeast from Houston-based independent Calpine Corp. for $1.6 billion. The deal for the six gas-fired combined cycle plants, with about 3,500 MW of capacity, closed in July.

■ Also in April, The Laclede Group, a St. Louis natural gas local distribution company, agreed to buy Alabama Gas Corp. (Alagasco) of Montgomery, from Energen Corp. of Birmingham, primarily an oil and gas exploration company. The $1.6 billion deal closed in September.

■ In June, NRG Yield, a unit of aggressive independent generator NRG Energy, agreed to buy Terra-Gen Power’s Alta Wind Energy Center for $2.5 billion. The 1,300-MW wind project in Tehachapi Pass in Kern County, Calif., is the second-largest wind farm in the world, with a 25-year power purchase agreement with Southern California Edison.

PwC’s Fago sees heavy M&A activity continuing. “Going forward,” he said, “we expect to see the M&A environment continue to pick up through a combination of regulated, merchant and YieldCo driven transactions.” For the third quarter, PwC said M&A activity among utility and power companies continued at a greater pace than in 2013, but was down from the second quarter, because of few blockbuster deals.

Big mergers have also been seen in companies serving the generation industry. The biggest recent move was GE’s $16.9-billion acquisition of Alstom’s power and grid division in June, a deal that had GE fending off a rival bid from Siemens. That merger got French regulatory approval in November.

Carving Out Value

The NRG deal, creating what analysts call a “yieldco,” leads us to the “carve-out” trend. yieldcos are a twist in the M&A tale. These hybrid corporate structures have been building, particularly in the area of renewable electric generation, for a year or so. Carl Weatherley-White of LightBeam Electric, a renewable power generating company, explains, “A YieldCo is a publicly-traded company that is formed to own-operate assets that produce cash flow. The cash is distributed to investors as dividends.” Yieldcos are a way to approximate the financial value of master limited partnerships, widely available ways to encourage investors by limiting the impact of federal corporate taxes.

The ScottMadden management consulting firm says yieldco are attractive because they lower the cost of capital, provide a mechanism similar to master limited partnerships, and are close to MLPs in tax advantages. The Internal Revenue Service has not approved the use of the MLP structure for generating projects. The firm says, “YieldCos have been established mostly for renewable asset development, but other steady earning assets could be amenable to being warehoused in a similar structure.”

The PwC analysis classifies yieldcos as one carve-out mechanism among several. Yieldcos, said PwC, “hold generating assets with long-term supply contracts,” one way to separate business lines that may not be complimentary. “Separating the discrete assets or business segments of a diversified company creates value in two ways,” says the report. “It can improve the core business by removing operations that no longer fit the company’s broader strategy and investment rationale. At the same time, it allows noncore businesses to find an audience among investors who may value it more highly as a stand-alone company.”

While carve-outs “may appear novel,” says PwC, “these transactions are a natural step in the evolution of a business. As the risk profiles and growth rates of various assets and business segments evolve, so will their consistency with the investment priorities of various stockholders.”

Carve-outs have been common in other industries. But in the power and utility segment, says PwC, these “structural separations have been rare,” because “companies are reluctant to part with assets except under duress. But markets have responded enthusiastically when utilities have carved out business units. Merchant power businesses spun off in the late 1990s and early 2000s fetched high stock market valuations at a time when growth prospects for such companies seemed limitless.”

Then the merchant power market melted down, a distinct disincentive to divest. But, noted PwC, some utilities have continued successful carve-outs. Duke Energy in the mid-2000s bundled its natural gas gathering, processing, and pipelines into a separate company, Spectra Energy (Figure 2). Said PwC, “That closed the value deficit, and then some.” The new company had a market value of $26 billion, and the two companies together had a market value in excess of $75 billion. “Even more impressive,” said the PwC analysis, “Duke’s price-earnings multiple has largely exceeded industry averages since the split.” That’s addition by subtraction: the parts are greater than the sum of the whole.

Likewise, carve-outs have been taking place in the generation vendor sector, such as with Babcock & Wilcox announcing in November that it plans to split its nuclear (its Government and Nuclear Operations business) and power generation businesses into separate companies.

Regulatory Leverage

FirstEnergy Corp., based in Akron, Ohio, and itself the product of a series of mergers of weak electric companies into a presumably stronger entity, is attempting what some observers have suggested is a “regulatory carve-out.” The company is proposing to essentially spin off some of its largest coal-fired and nuclear generating assets in Ohio and Indiana from the parent company to its Ohio distribution utilities. The utility subsidiaries would then sell the output from the plants into the PJM Interconnection’s competitive wholesale market, while serving the local retail customers under conventional cost-based regulation.

FirstEnergy has been hammered in its bids into the PJM capacity market in the last two years, leaving its coal and nuclear generation in a position of losing money. The company’s plan could offset losses in the competitive market with stable rates in the regulated market as a backstop. Cleveland newspaper ThePlain Dealer commented that the utility is asking the Public Utilities Commission of Ohio to approve “what amounts to regulated pricing from the power generated by some of its unregulated Ohio power plants.” Looking at the dynamics of the PJM capacity market, UBS utility analyst Julien Dumoulin-Smith said that “we believe management will need to continue to… shed assets.”

American Electric Power (AEP), based in Columbus, Ohio, is also pursuing a regulatory carve-out strategy. CEO Nick Akins told Wall Street analysts that AEP plans to move about a third of its Ohio generating assets to its distribution companies, if the regulators approve. In what Electricity Daily called an “elephant-to-mouse” deal, AEP has moved to transfer 800 MW of the 1,600-MW Mitchell coal-fired plant in Moundsville, W.Va., jointly owned with FirstEnergy, to AEP’s tiny Wheeling Power subsidiary. Wheeling Power is operated by AEP subsidiary Appalachian Power.

The deal, likely to win approval from West Virginia regulators because it could keep open a plant that otherwise would be closed, means that Wheeling would have to bid the power into the PJM market, where AEP has also had trouble making money. According to AEP, the deal to shift the company’s half-share of the plant to its subsidiary has been in the works for two years, indicating the complexities of such a deal.

PwC cautions that carve-outs aren’t an easy proposition. They require “the same level of analysis, planning, and attention to operational details as an acquisition,” says the firm. Utility executives need to “rethink the strategic positioning, capabilities, structures, and resource levels the legacy company will need as a smaller, more focused organization.”

Add carve-outs to the conventional business strategies of mergers and acquisitions. All are likely to figure in the way the power business conducts itself in the coming months and years. As the ScottMadden management consulting firm recently observed, “While utility consolidation continues, the sector lags other industries because of regulatory constraints and the inherent ‘local’ nature of energy infrastructure.” ■

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